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Foreign Policy: Let the Global Race to the Bottom Begin

August 27, 2015

Why China needs an overvalued currency to unwind years of undervaluation and manipulation.

On Aug. 11, the People’s Bank of China announced a decision to devalue China’s currency — the renminbi, or RMB — by 1.9 percent, by resetting the daily band within which it’s traded. That’s the largest single-day devaluation in the RMB since 1994 — and has important implications for the world’s two largest economies, that of China and the United States.

[Patrick Chovanec \ August 11, 2015 \ Foreign Policy]

In understanding the meaning of this move and the rhetoric around it, observers first need to recognize that U.S. political discussion surrounding the question of Chinese currency has fallen behind the times. Several years ago, the United States could advocate that Chinese policymakers let their currency float, while also advocating for a stronger RMB, confident that one would imply the other. Today, capital outflows from China are putting downward pressure on the country’s currency, meaning a freely traded RMB is likely to fall, not rise, against the U.S. dollar. This presents U.S. policymakers with a less obvious set of policy priorities and a more nuanced case to have to make for them.

The Chinese will try to argue they are just letting the market have its way. This is misleading: For years, the Chinese prevented the RMB from rising in value by buying nearly $4 trillion in foreign currency. The current market “equilibrium” is predicated on that massive distortion. The only way to get to a truly market-based RMB is to first unwind China’s past intervention by supporting the RMB and drawing down China’s foreign currency reserves. We shouldn’t want the RMB to float until that happens.

While some argue that China’s currency is now overvalued, what they ignore is that China needs an overvalued currency to rebalance its economy.While some argue that China’s currency is now overvalued, what they ignore is that China needs an overvalued currency to rebalance its economy. By maintaining a strong RMB, and unlocking the demand frozen in its reserves, China would help effect rebalancing, both internally towards a more consumer-driven economy (which Chinese policymakers publicly recognize they need) and externally towards a more balanced economic relationship with the United States (which would benefit both countries).

To its credit, this is what the People’s Bank of China had been committed to. It understood that a strong RMB means rebalancing toward a more sustainable growth model. But with the Chinese economy slowing, the central bank, or someone above its paygrade, lost their nerve and are instead trying to shore up China’s existing, failing growth model.

This is unfortunate, because it means China now joins Japan and Germany in trying to tap into U.S. consumption to drive their own growth, rather than unlocking their own excessive savings to create demand. In effect, they are trying to revert to the pre-2008 global growth model: relying on the United States going into greater and greater debt to function as the global consumer of last resort. This is not sustainable for them or for the United States. It’s a race to the bottom with no winners.

The significance of the central bank’s move is not the actual shift, of minus-1.9 percent, but rather the policy intention it signals. The U.S. Federal Reserve is widely expected to raise interest rates in the fall, based on a strengthening U.S. economy. Because Europe and Japan are still printing more money and pushing interest rates down in order to support their economies, this has attracted funds to the United States and caused the U.S. dollar to rise in relative value. It’s interesting that China’s recent devaluation almost precisely cancels out the 2 percent appreciation of the U.S. dollar in July, on a trade-weighted basis. It’s as though China is saying that it is not along for the ride as the Fed looks to tighten. That’s a mistake, though, because China actually needs to take away the punch bowl of easy credit more than anyone.

At any rate, devaluation won’t actually solve the Chinese economy’s problems. China has outgrown the export-led growth model that it relied on for decades, and there’s no going back.China has outgrown the export-led growth model that it relied on for decades, and there’s no going back. What devaluation will do is drive even more capital out of China, putting that much more downward pressure on the RMB. A 2 percent devaluation will satisfy no one and will make it that much harder for the People’s Bank to support the RMB against further depreciation.

The practical effect for the U.S. economy from RMB devaluation is a revival and strengthening of the head winds from a strong U.S. dollar that slowed the American economy in the fourth quarter of 2014 and the first quarter of 2015. In the first quarter, the widening trade deficit from a strong U.S. dollar shaved almost two full percentage points from U.S. GDP growth. It also had a big negative impact on the U.S. dollar value of U.S. corporate earnings overseas, which hit their bottom line. This seemed to be getting better in the second quarter — now all bets are off.

Given these concerns, and the actual impact on third quarter growth, the Fed may be less inclined to raise interest rates in the fall. This may offset some of the negative impact, but it’s not where the United States — or the world — would like to be. Rather than rebalancing to unlock global demand from chronic surplus countries like China, which can afford it, we are seeing the beginnings of a slower-growth, beggar-thy-neighbor scenario for the entire global economy.